Pakistan’s August CPI (Consumer Price Index) has spiked to 11-months high of 8.55% versus 8.26% in the previous month.

On MoM basis, inflation stood at 1.16% as against 2.02% in July 2013, while the average inflation in 2MFY14 stood at 8.41%.

Though we still wait for detailed break-up, we believe the spike in inflation is a reflection of hike in food prices due to Eid festival and petroleum prices. In August, govt increased price of Petrol and HSD by 2.6% and 2.8%, respectively. In food segment, 13.5% increase in chicken prices and 3.6% hike in wheat prices have also lent its due hand, we believe.

As numbers are in line with our assumptions, our average FY14 inflation forecast may remain in the range of 9-10%.

August CPI (Consumer Price Index) stood at 8.55% versus 8.26% recorded in the preceding month. The reading falls within our expectation range of 8.3-8.6% (Aug 23’13 report titled “Next MPS: Four important considerations”)

On a MoM basis CPI stood at 1.16% versus 2.02% recorded last month, while average inflation during 2MFY14 stood at 8.4% against 9.3% in the same period last year.

The data reveals that high MoM inflation primarily came from the 2.07% increase in the food head (weightage of ~35%) with 1.8% increase in non-perishable items and 3.5% increase in perishable items. We believe the recent flash floods created inflationary pressures in this head.

Other major heads, such as the housing index and transportation rose by 0.03% and 0.95% respectively. These heads cumulatively have a weightage of ~37%.

During Aug’13, core inflation also witnessed a slight increase, up 0.6% MoM while it stood at 8.5% compared to the same month last year.

Going forward, rationalization of power and gas tariffs is likely to induce inflationary pressure and we estimate the average FY14 inflation to clock in the range of 9-10%.

Economy: Increased likelihood of DR hike in upcoming MPSAug-13 CPI clocks in at 8.55%CPI inflation for Aug-13 clocked in at 8.55%, marginally higher than Jul-13 CPI of 8.26%. 1.16% MoM uptick in CPI reading is alarming. However, we see some of the inflationary pressures having resulted from tailwinds of increased demand of food and beverages during Ramadan / Eid. Increase in fuel prices also impacted CPI reading to some extent.50bps hike in discount rate likelyWith real interestD rate based on Aug-13 CPI shrinking to a thin 45bps; lowest since Jun-12, we see an increased likelihood of interest rate hike in upcoming monetary policy scheduled to be announced on September 13th. Increased inflationary pressures which would likely be compounded by higher fuel / electricity prices with expansionary fiscal policy and entry in to IMF program provide little room for continuing the existing monetary stance.Some trends are alarmingCore inflation has also been on the rising trend. NFNE and trimmed core increased by 150bps and 120bps MoM respectively during Jul-13, and 60bps MoM in Aug-13. YoY NFNE and Trimmed Core inflation clocked in at 8.5% and 7.9% respectively during Aug-13. WPI trend also remains disturbing, with WPI inflation having risen to 8.3% YoY in Aug-13 from a low of 4.1% in May-13.

The IMF Executive Board has approved a 3yr Extended Fund Facility (EFF) for Pakistan amounting to US$6.64bn. This will entail initial disbursement of US$544mn (as opposed to recent news reports calling for immediate release of US$2bn), with the remaining amount to be disbursed evenly over the duration of the program, subject to quarterly reviews. While the detailed LoI has yet to be released, key program details include:• Immediate focus on stabilization (fiscal/monetary tightening) which could limit GDP growth to 2.5% in FY14. However, the program envisages GDP growth rising to ~5% by program end. • Reduction in inflation to 6%-7% by end program (however, price pressures may rise in near-term where CPI may reach 10% by FY14 end) • Increasing SBP reserves to 3.5 months by end program (assuming oil prices and exchange rate remain stable, this implies an amount of US$13.5bn-US$15bn vs. US$5.2bn at present ). In our Economic Focus ‘Is Currency Weakness Here to Stay? ’ dated Aug 20’13, we mentioned that the total import cover will reach 4.6 months by Dec’14 assuming the privatization program is successful.• Reducing fiscal deficit to 3.5% of GDP by end program, from 8.0% of GDP at present.• Reforming the trade regime, as well as PSEs through restructuring/privatization programs. Regarding the latter, the Privatization Commission has formally prepared a list of 71 Public Sector Entities (PSEs) for divestment on fast-track basis. The list includes banks, insurance companies, energy sector companies, PIA, National Fertilizer Company (NFC) and Pakistan Steel Mills (PSM) where we believe key names such as OGDC and PPL may make the cut for the first round of privatization (SPOs).Among the positives, according to Jeffrey Franks, the IMF’s mission chief for Pakistan, the World Bank, the Asian Development Bank and other partners have offered significant financial support for the required adjustment and reform policies in addition to the IMF package of US$6.6bn. Going forward, critical checkpoints in the immediate term include 1) formal release of Pakistan’s Letter of Intent to the IMF which should outline reforms in greater detail and 2) the SBP’s MPS announcement on Sep 13’13 which should set the tone for interest rates across the next year or so. Regarding the latter, we understand that while reduced currency intervention is a program precondition, discount rate hikes are not and remain dependent on inflationary outlook. As such, considering inflation remains below 9%, we believe the central bank may hold rates in the upcoming MPS.

International Monetary Fund (IMF) executive board, as expected, has approved US$6.64bn loan for Pakistan with the initial disbursement of US$540mn, while remaining amount will be distributed in 3 years after each quarterly review. The 36 month program primarily aims at macroeconomic stability by bringing budget deficit down and addressing chronic balance of payment issues, which will require some fiscal and monetary tightening. Moreover, due to IMF’s endorsement, we could also see more aid flows from other agencies such as Asian Development Bank, World Bank, Islamic Development Bank etc. And if the new government’s economic and energy sector reforms are implemented properly, we cannot rule out improvement in Pakistan’s outlook by rating agencies.

Pakistan’s history with IMF

In last 25 years, Pakistan has entered into 10 International Monetary Fund (IMF) programs. However, most of the arrangements were not fully implemented due to inability to bring structural reforms. Out of total agreed amount, Pakistan has withdrawn 7.0bn SDR which is 76% of the committed funds.Comments on inflation and interest rates

Following are the few comments on inflation and interest rates mentioned in letter of intent (LoI), Jeffrey Franks IMF Survey and IMF Press release

• Negative impact on economic activity will be ameliorated by structural reforms and more accommodative monetary policy stance early in the program.

Previously, we were of the view that govt will increase 50bps in the monetary policy scheduled on September 13, 2013 because of IMF pressure, though inflation does not warrant any hike. However, statements and intentions from both side shows that SBP may not raise rates immediately.

The MoF (Ministry of Finance) has released the Letter of Intent submitted to the IMF, titled “Memorandum on Economic and Financial Policy for 2013/14-2015/16” that is to be supported by the International Monetary Fund (IMF)’s 36 month EFF (Extended Fund Facility).

The document provides much needed clarity on the future policy direction (fiscal and monetary) by the government and thus potentially eases the nerves of equity and bond market players. On the fiscal front, the detailed document is in line with recent reports circulating in the media, but provides a clearer picture on the monetary side.

The document states:

“Inflation will initially increase, due in part to some weakening of the rupee as reserves are rebuilt. However, monetary policy will likely be tightened in later years to help bring inflation down to the 6-7 percent range by the end of the program period”

Furthermore,

“Inflation reduction will not be a primary focus of the first year of the program so as to mitigate the impact of the envisaged fiscal contraction”.

And,

“To ease some of fiscal adjustment effects, the program initially envisages a moderate monetary policy, with policy tightening in years two and three, as exchange rate pressure eases, to bring inflation down to the 6-7 percent range. To reduce inflation, monetary accommodation of fiscal deficits will be scaled back considerably and policy rates will be set prudently to ensure positive real interest rates.”

As per our understanding with regards to this new information, the central bank is likely to continue an accommodating monetary policy stance in its upcoming MPS scheduled to be announced on Sep 13’13. The focus of the policy makers would once again be on promoting investment and highlights increased chances of maintaining “status quo” in the upcoming MPS.

The document also provides insight on the future exchange rate direction; the rate is likely to be adjusted to keep competitiveness intact.

Inflation at 8.5%, Interest Rate at 9%. Real Interest Rate just at 0.5%. With Inflation expected to rise significantly in next 2 months. Real Interest Rate may turn Negative. SBP must be in a dilemma while deciding MPS.

The KSE-100 Index gained 2.56% yesterday with the rally led by several scrips in leveraged sectors such as Cements and Chemicals. In this regard, we believe that the recently released LoI and Memorandum on Economic and Financial Policies submitted to the IMF hint at a possible postponement in interest rate hikes. Specifically, the GoP has indicated that it intends to keep monetary policy ‘moderate’ over the first year of the program, something that the IMF may potentially be on board with. In our view, this may entail pushing forward the interest rate hike cycle into 2HFY14. Other key takeaways from detailed documents include updates on the privatization program (we think names such as OGDC, PPL, HBL and UBL may make the first cut for divestment through block sales/SPOs/int’l listings etc.). On a cautionary note, the GoP appears to be serious on increasing tax revenue through a new gas levy by Dec’13 which could potentially have adverse implications for selected sectors. That said, in the near-term we believe the market rally may extend for leveraged sectors while we remain positive on E&P and Banks from a medium-term perspective.

Macroeconomic implications: The 3yr IMF EFF program amounts to US$6.6bn with initial disbursement of US$544mn followed by quarterly payments, subject to reviews. An amount of US$5.5bn is also expected over the program period from sources such as the World Bank, ADB, UK and USA. The GoP believes that partly due to immediate-term belt-tightening measures, FY14 GDP growth may come to 2.5% before improving to 4.5%-5% by FY16. The GoP has also indicated that while the inflation target by end-program is 6%-7%, inflation may initially increase. That said, the GoP envisages a ‘moderate’ monetary policy in the first year of the program to be followed by policy tightening in years two and three. This firms our view that interest rates will likely remain unchanged in the Sep 13’13 MPS while the interest rate hike cycle may be pushed into 2HFY14. Channel checks with relevant authorities also confirms the same where we understand that while reduced currency intervention by the central bank was a pre-condition, interest rate hikes are not.

Privatization/Restructuring on the cards: A list of 65 entities has been prepared for divestment on fast-track basis. In this regard, the roadmap for 30 firms will be announced by end-Sep’13 with plans for the remainder to be completed by end-Dec’13. In our view, names such as OGDC, PPL, HBL and UBL may make the first cut for divestment through block sales/SPOs/int’l listings. We estimate that the GoP can easily raise an amount of ~US$2bn if its divests a 10% stake in each of these four entities. Other measures on this front are 1) planned privatization of PIA by divestment of a 26% stake to strategic investors by end-FY14 and 2) preparation of a more detailed plan by end-Dec’13 for compliance of all banks that fall below minimum CAR (four banks at present; one public, three private).

Sector implications: The GoP has indicated it intends to introduce a new gas levy by Dec’13 with the aim to raise tax revenue by 0.4% of GDP or ~PkR100bn. We believe this could hold negative implications for sectors such as Cements and Fertilizers given the recent deterioration in pricing power; the former has already been bickering over pass-through of recent cost increases while for Fertilizers, domestic urea price (ex-GST) of PkR1,496 is at a slim discount of 5% to int’l urea which may limit pass-through ability. In the near-term however, leveraged plays may outperform on an anticipated postponement in the interest rate cycle where we flag ENGRO and DGKC as preferred plays. We also retain a preference for US$-hedged revenue streams present in E&P and IPPs while Banks continue to look attractive from a medium-term perspective (preferred plays: UBL and BAFL).

After the IMF announced its fresh funding program for Pakistan, to the tune of USD6.64bn last Wednesday, with a very low front-load of ~USD545mn (rest subject to quarterly criteria deliverance, details given on the next page), the Ministry of Finance (MoF) also unveiled its Letter of Intent (LoI) that it submitted before the finalization of the new extended funding arrangement (36-month EFF with 4.5-10yrs repayment period at an estimated rate of 3%).

As per the LoI released by the MoF, Pakistan requested the lender for a waiver on some factors/targets for initial years where the IMF seemed to have agreed to no-rate increase request jointly put up by the MoF and the SBP. The text of the LoI says no interest rate increase at least in the first year of the program while the later years should see real interest rates in the positive. This means the gov’t authorities have now been accommodated with a full-year FY14 as far as monetary tightening is concerned while the central bank vows to keep price stability and reserves building efforts as priority. This flexibility, when weighed in against the last SBA facility, looks a better deal for Pakistan as there was no such liberty was accepted though other performance criteria largely remains the same.

Go-ahead on no-rate increase a fresh breather for capital market

As the LoI was released, KSE100 shot up by a massive 500pts yesterday while yields in the secondary market went largely down in the range of 4-11bps on various tenure papers. After the relative comfort on interest rates, we expect equities to sail through a better flow and sustain performance ahead, especially the leveraged sectors such as Textiles, Cement, Fertilizer and few smaller ones.

Outlook

With a stable medium term outlook on interest rates, where central bank is expected to strife for keeping investment and growth supportive stance, we stick to our market outlook of a sustained performance by equities on the expectations of better Jul-Sep’13 quarter earnings, at least for the sector benefiting from the recent PKR depreciation (5% since Jul’13, 8% Jan’13 to date on closing basis), such as IPPs, Textiles, Telecom, E&Ps and Chemicals, in addition to the support provided through the recent cut in the policy rate by the central bank (50bps to 9% in its last MPS).

We believe, the new IMF deal though stands with a strict performance criteria on a quarterly basis, privatization news flow ahead (30 PSE’s to be announced before end Sep’13) and a status quo in the upcoming monetary policy should provide KSE reasons to sustain high returns. Any delay or the opposite in any of the mentioned developments would keep Pak equities in check. Currently, the KSE100 is trading at a 2013 estimated PE of 8.0x (48% discount from regional average) and an attractive DY of 6.0% (59% discount from regional average).

""The State Bank on Monday mopped up Rs202 billion from the banking system at eight per cent, which, according to bankers, reflects the interest rate regime stays unchanged for another couple of months.""

""The State Bank on Monday mopped up Rs202 billion from the banking system at eight per cent, which, according to bankers, reflects the interest rate regime stays unchanged for another couple of months.""

Banks for short will be under pressure, but in long run the most safe heavens like NBP, BAFL, UBL for satta BOP and from third tier NIB. Buy on dips after DR announcement can give good return.

A policy is referred to as contractionary if it reduces the size of the money supply or increases it only slowly, or if it raises the interest rate. An expansionary policy increases the size of the money supply more rapidly, or decreases the interest rate. Furthermore, monetary policies are described as follows: accommodative, if the interest rate set by the central monetary authority is intended to create economic growth; neutral, if it is intended neither to create growth nor combat inflation; or tight if intended to reduce inflation.

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As received from my BankerIMF has approved $6.6 billion loan for Pakistan yesterday with first tranche of $540 million to be released immediately. After reviewing the progress every quarter to see achievement of targets, similar amount would be released every quarter with about ($2.2 billion for FY14) ~ almost offsetting the IMF payments that the country has to make during remainder of FY14. As highlighted earlier, IMF’s approval would provide short term breather for the exchange rate, however, stability in the exchange rate would only be possible on the back of inflows from other donors agencies ~ currently expected to be around $3.5 billion.

The ministry of finance has also released the Letter of Intent submitted to the IMF (attached with the email), which provides much needed clarity on the future policy directions. Specifically on the monetary policy side, the document provides a good insight. The key excerpts are as follow:

“Inflation will initially increase, due in part to some weakening of the rupee as reserves are rebuilt. However, monetary policy will likely be tightened in later years to help bring inflation down to the 6-7 percent range by the end of the program period”

And,

“To ease some of fiscal adjustment effects, the program initially envisages a moderate monetary policy, with policy tightening in years two and three, as exchange rate pressure eases, to bring inflation down to the 6-7 percent range. To reduce inflation, monetary accommodation of fiscal deficits will be scaled back considerably and policy rates will be set prudently to ensure positive real interest rates.”

As per our understanding of this document, the SBP is expected to follow an accommodative monetary policy with chances of status quo in Sep’13 MPS looks brighter ~ which is in line with our view as highlighted earlier. Importantly, the document also highlighted the objective of maintaining positive real interest rates ~ meaning chances of status quo for Sep’13 (as real interest rates are still positive), while rate hike would be possible given higher inflation range for Oct’13 onwards amid adjustment of electricity tariff.

In our opinion, the details of this LOI has given comfort to our interest view ~ Status-quo in Sep’13 on the back of positive real interest rates while gradual rate hike from Nov’13 MPS on the back of higher inflation as it would bring real interest rates in a negative zone while the SBP’s aim appears to be ensuring positive real interest rates.